It’s not the rising prices in Toronto or Vancouver. It’s not the single 7% drop in house prices the GTA experienced in May. It’s not even the fact that the rise in incomes of families don’t correlate to the price of houses in Canada. It’s the fact that many people are using their homes as ATMs to sustain their standard of living. That’s the scariest part of the housing market rise.
It’s one thing to have unsustainable housing prices, but to have families and individuals borrow against their already gigantic mortgages is the thing of epic demise. I can honestly speak from experience that borrowing against your home to fund anything: Vacations, cars, more real estate, stocks, renovations, or even your kid’s education is a bad idea. They are ALL bad ideas. Every single one of them. Read that again. It’s a BAAAAAAD idea. Stop doing it!
Home Equity Line Of Credit. Consider it the bank’s version of crack cocaine. First off we need to understand just what these are and why people love them. A HELOC is essentially a loan that the bank gives you with a house as being collateral for the loan. Since a house is such a stable asset (doesn’t everyone think that) the bank is willing to give you a great interest rate, usually around prime + 1 or 2 percent.
Isn’t that fabulous? Now instead of racking up credit card interest rates of 23% you can borrow against the home at a mere 2 or 3%. FREE MONEY! Why does the bank do this? Why do they allow you to borrow from the equity in your home? Because they make MONEY! They WANT you to borrow. They don’t care if you go deeper into debt. THEY WANT THAT. And you’re more than willing to oblige. You’ll just keep coming back for more and more. And dealer, ahem I mean the bank, just keeps feeding you more and more.
By law the bank is allowed to lend you up to 65% of the equity you have in your home, 80% if you roll that last 15% into your mortgage. What does this mean?
- If you have say a $500K mortgage, on a $900K home, but it is now currently assessed by the bank at $1.4M dollars. You have $900K equity in your home. That means the bank is willing to lend you up to $720K on a line of credit. $720K!
- That last 15% or $170K can be rolled into your mortgage. That brings the total available credit up to $890K. Sweet enough for that second investment home!
Want a new Audi? Renovate that bathroom? Buy that cottage in the Haliburtons? Why not? You just have $890K of money at your disposal by buying a $900K home! Why not try your luck and buy two or three more homes and try to leverage up some more? Isn’t that what everyone else is doing anyways? Don’t you just love debt and leverage?
Lacking Cash Flow
There are many reasons why people are dipping into their homes to fund their lifestyles:
- Home prices are high and thus people are becoming house poor
- People want instant gratification and they want it now
- Greed. Money is cheap and it’s easy to leverage a house into more investments
- Ignorance to risk. This generation has never experienced high interest rates or falling home prices.
There are many arguments for buying a home in Vancouver and Toronto, but cash flow isn’t one of them. It’s quite easy to rent a million dollar home in Toronto for around $3000/month whereas someone owning it might end up paying around $4500 a month with property taxes, mortgage payments and maintenance all factored in. That extra $1500 is a lot of money. That could be vacation money, car payments or RESP contributions. All of this can’t be possible while owning because of the large monthly costs necessary to maintain a home.
The problem with an expensive primary residence is that cash flow is constricted. Those monthly payments must be met, otherwise the home could be repossessed. That’s a scary thought; however, we still feel entitled to having a life outside of just owning a home. Where does the money come from for paying for dates? How about that new Louis Vuitton bag or those Jimmy Choo shoes? The trip to the Bahamas? There’s just not enough money for those things in our lives with such large house payments. But I really want those shoes. I really want those SHOOOOOES!
The problem is all the money is tied up in the house. It’s not printing money for you on a monthly basis to pay all the bills, but heck that bad boy has gone up 50% since you bought it. So how do I get my equity out? HELOCs! Enslave yourself to the banks so now your profits are taxed by the banks. Congratulations, you’ve sold your soul to corporate Bay Street. They’re not stealing your money. You gave it away willingly! (And lined my pockets in the meantime)
The great thing about HELOCs is that you only have to pay the interest every month. The bank is more than happy for you to carry an outstanding balance. That means most people treat that HELOC like a free money bank account where funds can be withdrawn with little consequence. It’s only 2% interest, right?
Well using a home, with an already gigantic mortgage, as collateral and adding more loans that are so easily accessible is just a loaded gun waiting to go off. It’s all fun and dandy when home prices are rising double digits, but the moment prices fall even the slightest or when mortgage renewal time comes around with higher interest rates, people could be in a world of hurt.
See just like the great depression when people were buying on margin for stocks, leveraging to the hilt on a house works the same way. What happens when the house price fall say 10%, and now the equity in your home doesn’t cover the loan you borrowed in your HELOC? Well the bank comes calling your for your money. Take this example:
- You borrowed 65% of the equity you had in your home at a previous point in time which was $100K, so you took $65K out
- House prices dropped and now you only have $90K equity in your home
- By law you are only allowed to borrow $58.5K now, but you’ve spent that $65K already
- You are now short $6500 and the bank asks you for the money and they want it right now
Living paycheque to paycheque might have been bad, but now the bank asks for the $6500 that you don’t have to cover the shortfall. What now? There’s no cash left and you’ve maxed out all your credit. Well… you’ll be forced to sell the home that’s what. And now not only are you forced to sell on quite possibly a falling market, you might not even be able to cover the rest of the outstanding mortgage. Holy SHIT! Life is failing before your eyes.
When the assets that you have can no longer cover your debt, that when the term bankruptcy comes into play. And we all know what a negative connotation that has. Just ask President Trump.
Should We Care?
Maybe we shouldn’t be too worried about the rising debt load. Besides, home prices continue to rise to the stratosphere, so who really cares? Those that don’t have houses are just being Debby downers and wish they could join the party. Most of the wealth in Canada has shifted mainly towards home owners, as housing prices continue to climb at astronomical rates. Let the haters continue to hate.
The real big fear is what type of contagion our financial system may sustain if a few bad apples do end up defaulting on their massive loans? Well nothing. That’s because the federal government insures most of our mortgages through CMHC, so the banks don’t take any hit, the taxpayers do.
Honestly, if we as Canadians don’t mind paying higher taxes, more fees and facing stiffer future penalties for being financial delinquents, then by all means, let the party continue and spend to our hearts delight. But if you have any semblance of trying to be financially responsible for not only yourself, but your fellow Canadians, then maybe think twice before playing with fire.